Is the value rally defying ESG risks?

Monthly column from Global Equities on sustainability investing. Global Equities team analyst Masja Zandbergen asks whether the rally in value equities is coming at the expense of sustainability.

Masja

Zandbergen - Albers

Head of ESG integration

Investors will have noticed that best-in-class ESG funds underperformed the wider indices in 2016. As an ESG integration expert, I am often asked why this occurred if sustainability is such a good idea?

ESG integration does not equal best-in-class

First of all, looking at one-year performance for a strategy which is truly meant to be long term does not make sense to me at all. Second, as an ESG integration specialist, I am not involved in ESG best-in-class strategies. ESG integration is about how financially material ESG issues affect companies’ strategies, policies, and in turn, their financial performance. Nonetheless, our global fundamental strategy, which invests in companies with good free cash flow and the potential to reinvest at high returns on invested capital – and for which the analysts incorporate ESG in their analysis – experienced some of the same issues. I think that it was not because ESG as a ‘factor’ performed badly: it was because the long-since established ‘value’ factor performed extremely well.

A value basket would have given you a large exposure to ESG risks

And what companies were deemed to offer ‘value’ in the beginning of 2016? Energy, metals & mining and financials would have been very well represented in the value basket. And it is precisely these sectors that are under-represented in your typical sustainable fund because of the ESG risks that they pose. In 2016, however, the global metals & mining index outperformed the world index by almost 50%, and the energy index outperformed by almost 20% in US dollar terms. So does that mean ESG risks are off the table? By no means: the main driver behind this rally was coal, iron ore and oil prices all recovering from their lows, and from companies in these sectors having rigorously cut capex spending and using the cash to deleverage their balance sheets. Furthermore, valuations were pretty much bombed out.

A matter of perspective: taking the long view

Incorporating ESG into our investment process in global equities in 2014 led to the conclusion that for these companies with a low return on invested capital and low free cash flow profiles, having high ESG risks also increases their cost of capital, and therefore led to a lower valuation estimate by our analysts. So from all sides, these names were deemed to be of no interest for investment. And that decision turned out to be a good one from a longer-term perspective, because over the period 2014 to end 2016, these names have still underperformed dramatically (by 44% and 35% respectively).

Investing means looking forward

As this rally seems to have stalled a bit this year, the million-dollar question is of course whether it can continue going forward. As the names in these sectors have become more investable (as free cash flow generation has improved), we would now consider researching them more closely. But in our analysis, ESG risks will certainly be taken into account, and this will influence our valuation on those names.

So taking into account sustainability in your investment process (one way or the other) can make an impact on your performance from year to year, just like having a rigorous and strict investment approach does. I am convinced that in the long run, both should enhance investment decision making and investment performance.